Abstract: (15 Views)
This review paper examines the theoretical foundations and empirical limitations of two cornerstone assumptions in international macroeconomics: complete markets and uncovered interest parity (UIP), as derived within the standard New Keynesian Small Open Economy (NK SOE) framework. Theoretically, the assumption of complete international financial markets yields a strong risk-sharing condition, linking domestic consumption directly to world consumption and the real exchange rate. Simultaneously, allowing households to choose between domestic and foreign bonds delivers the UIP condition, which posits that interest rate differentials are entirely offset by expected nominal exchange rate depreciation. While these derivations provide a tractable and elegant benchmark, their empirical predictions systematically fail. Risk-sharing is rejected by the data as shown in the Backus-Smith puzzle; whereas UIP is consistently violated by the forward premium puzzle. Confronted with these persistent anomalies, the literature has transitioned away from the complete markets paradigm toward richer frameworks that incorporate incomplete markets, financial frictions, deviations from rational expectations, time-varying risk premiums, and pricing-to-market behavior. This survey traces that evolution, highlighting how each theoretical modification strives to reconcile the elegant micro-founded model with the unruly dynamics observed in actual exchange rates and international consumption patterns.
Keywords: complete market, international risk sharing, uncovered interest rate parity, risk premium, terms of trade, new Keynesian open small economy
Type of Study: Research |
Subject:
economic development, regional economics and growth
Received: Aug 17 2026 | Accepted: May 31 2026
Received: Aug 17 2026 | Accepted: May 31 2026
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